Inflation and the Repo rate

The effect of inflation for a lay person is the prices of everything going up over the years, or in other words too much money chasing too few goods. For instance the cost of one loaf of bread purchased by my father was 50 paise when he was a kid, now it is worth Rs.10. Thus, inflation makes the worth of money to reduce.

There are two kinds of Inflation indices in use in India;
1. Wholesale Price index (WPI), issued by the Ministry of industry. It is the most commonly discussed index of inflation.
2. Consumer Price index (CPI), issued by the Ministry of Labour.

The composition of these indices is different, with food articles constituting 57% of weightage in CPI for industrial workers, as against 27% in WPI. A more than proportionate rise in prices of food articles leads to a higher rise in CPI as it is happening in the current scenario.

Causes of Inflation
Broadly, there are two categories of inflation:

• Demand-pull Inflation or the Demand side Inflation: caused by increase in aggregate demand due to increased Govt. and individual spending. The propensity to buy increases with an increase in wage rates.

• Cost-push Inflation or the Supply side Inflation: caused by fall in supply due to increase in supply of inputs. For example, due to a crop failure the supply of wheat in the market is reduced, the sellers will respond with a increase in prices of the existing stocks.

Money supply plays an important role in deciding the level of inflation. The Government, in a crises situation (like war) may stimulate demand by printing Currency notes (deficit financing).

Effects of Inflation on the economy
A small amount of inflation is believed to have a positive impact on the growing economy. An attempt to maintain a zero inflation level may lead to falling prices, losses and unemployment. This situation may be accompanied by downward movement in wages and output and is called ‘Deflation’. Moderate inflation also serves as an incentive for the ‘savers’.

Controlling Inflation
Central bank of the country (RBI in our case), have used several monetary policy measures to contain inflation. It is virtually impossible to achieve a zero percent inflation over sustained period of time, because it is impossible to prevent wage earners from demanding higher wages. The most common methods of controlling inflation are:
• Slow growth of money supply
• High interest rates

REPO Rates and Inflation
The hike in REPO rates by the central bank is an indication to lenders to increase their lending rates, thereby reducing the excessive demand. In addition, the central banks indulge in open market operations, ie. buying and selling Govt. securities in the market to influence short term liquidity, on a day to day basis. Sometimes, the reserve requirements are also changed to manage liquidity. In
the recent past, RBI has hiked cash reserve ratio (CRR) on three occasions to suck the excess liquidity from the system.

These are demand side factors of controlling inflation. However, in the longer run, supply side management is more effective in controlling inflation. The govt. tries to augment production, supply of the scarce commodities to have a sobering effect on their prices. For example, if the prices of cement have gone up in the past, the govt. can allow import of the commodity, and at the same time grant new licenses to enhance the capacity to produce cement in the economy.